Europe has turned a corner but what will the German elections bring

The recovery has begun. After six consecutive quarters of declining output the eurozone economy finally emerged from recession in the second quarter of this year. The monetary union, in aggregate, grew by 0.3 per cent compared with the first quarter, although the annual comparison remains negative at minus 0.7 per cent.

Encouragingly, the improvement in activity has been widespread. The core economies along with the periphery all recorded either an acceleration in growth or a fall in the rate of contraction.

The distribution of growth comes as no surprise: core Europe, led by Germany, Finland and France, made the largest contributions to the aggregate, while Italy, Spain and the Netherlands all remain in recession.

The only surprise was Portugal, which recorded a huge – 1.1 per cent – increase in activity, making it comfortably the best-performing member state. Nevertheless, average quarterly growth of 0.4 per cent over the first half of the year is very good, given the fiscal situation.

The second-quarter GDP growth figures were mostly stronger than the consensus forecast among economists, including our own. Last quarter we pushed back the start of the recovery to the third quarter on the basis of a lack of pick-up in activity indicators, the volatility caused by the crisis in Cyprus and the potential impact of the devaluation of the Japanese yen.

As it happens, activity indicators have rebounded sharply over the past few months, while financial conditions remained relatively robust despite the Cypriot crisis. However, there may yet be an impact from the fall in the yen as the time-lag on currency movements tends to be long.

Our favourite two European leading activity indicators, the Belgian National Bank survey and the Markit composite purchasing managers’ index, correctly predicted a return to growth in the second quarter.

The most recent readings are even more encouraging. Both surveys suggest that year-on-year growth will turn positive in the third quarter. To achieve this, quarter-on-quarter growth would have to rise to 0.7 per cent.

Given the upside surprise in the second quarter data, and the positive momentum signal coming from the leading indicators, we are revising up our growth forecasts for the coming quarters.

However, given the ongoing headwinds of deleveraging and austerity, we are more cautious than the private business surveys. Constraints on public investment and spending should weigh on growth and would not be picked up in the surveys.

We have revised up our eurozone quarterly profile for almost every quarter until the end of 2014, taking the annual average GDP forecast for 2013 from minus 0.7 per cent to minus 0.5 per cent, and the 2014 forecast from 0.6 per cent to 1 per cent.

Surveys of consumer confidence have also been improving in the eurozone as a whole, particularly in Germany. The continuing improvement is key to supporting a sustainable recovery. As household consumption increases, growth in business investment eventually resumes, helping to create jobs and supporting consumption further.

Domestic demand has not been the only source of growth. Europe’s external performance has been impressive, especially against a backdrop of a stronger currency.

The balance of trade in goods and services as a share of GDP is at its highest level since the formation of the eurozone, while the current account – the wider measure of cross-border flows – is at an even higher level, suggesting that the monetary union is also receiving inward net investment income and transfers. This has also helped the euro to appreciate against other currencies.

Political risk to return

Risk investors have enjoyed a relatively quiet period from a political perspective in Europe. The parliamentary elections in Germany have essentially put all European-level decision-making on hold, meaning that errant member states are not being chastised for missing austerity targets, banks are not being threatened with new regulations and there is a pretence that Greece is on a sustainable footing.

This last point is not totally true. Peer Steinbrück, leader of the opposition centre-left Social Democrat (SPD) party in Germany, has recently broken the silence on Greece by admitting that the Hellenic republic would need another debt restructuring – a view we have maintained since the last bail-out.

Angela Merkel, leader of the CDU/CSU coalition, and the incumbent Chancellor, replied by stating that allowing Greece into the eurozone had been a mistake that had weakened the European stability pact.

At the moment the biggest losers from the election look likely to be Merkel’s junior coalition partners the Free Democratic Party (FDP), led by Rainer Brüderle.

The FDP’s anti-bail-out stance for peripheral Europe has gone down badly with the German electorate, which clearly favours a softer, pro-solidarity approach. Indeed, the FDP is at risk of failing to meet the minimum 5 per cent of the vote required to enter the Bundestag.

Merkel’s Christian Democratic Union and its Bavarian sister party the Christian Socialist Union are likely to increase their share of the vote. Although the CDU/CSU won only just under 34 per cent of the popular vote at the last election they won 40 per cent of the seats in parliament, which suggests the coalition’s six-point increase in the polls should boost the number of seats it wins.

The other two key parties are the previously mentioned SPD and the Greens. Based on an average of the past 10 voting intention polls, Merkel and Brüderle will not have a big enough majority to form a ruling coalition.

We expect Merkel to form a coalition with either the SPD, the Greens or both, and retain her crown as Chancellor and unofficial eurozone leader.

Regardless of the exact permutation that plays out, we expect the German government to take a softer stance on peripheral Europe. This would not mean doing nothing. Greece clearly needs another bail-out, and we believe the burden of the next debt restructuring will fall on official institutions and ultimately European taxpayers.

However, such a coalition will not be good news for all market participants.We expect the next government to take a tougher stance towards banks, and investors in banks (both equity and debt investors).

In an attempt to steal votes from the SPD, Merkel’s latest budget included plans to introduce wealth taxes, levies on banks and financial transaction taxes – all likely to be advocated across Europe in the future. This is significant for Spain and Italy as their banking systems continue to need restructuring.

It appears that Merkel is now in favour of bond holders and depositors having to take hits on their investments, as happened in the Cypriot crisis.

The big risk is that against a backdrop of a more hostile stance towards banks in Germany, the European Central Bank presses for an accelerated recapitalisation process, which inevitably leads to banks cutting back lending when they cannot raise capital through equity issuance.

Overall, the German election itself is unlikely to yield a result that will dramatically change the outlook for Europe, but the passing of the event will restart the necessary rehabilitation process, and along with that will come increased political risk and market volatility.

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